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Nature and Types of Working Capital

The term working capital refers to current assets which may be defined as (i) those which are convertible into cash or equivalents within a period of one year, and (ii) those which are required to meet day to day operations.  The fixed assets as well as the current assets, both requires investment of funds.  So, the management of working capital and of fixed assets, apparently, seem to involve same type of considerations but it is not so.  The management of working capital involves different concepts and methodology than the techniques used in fixed assets management.  The reason for this difference is obvious.  The very basics of fixed assets decision process (i.e., the capital budgeting) and the working capital decision process are different.  The fixed assets involve long period perspective and therefore, the concept of time value of money is applied in order to discount the future cash flows; whereas in working capital the time horizon is limited, in general, to one year only and the time value of money concept is not considered.  The fixed assets affect the long term profitability of the firm while the current assets affect the short term liquidity position.  The fixed assets decisions are irreversible and affect the growth of the firm, whereas the working capital decisions can be changed and modified without much implications.

Managing current assets may require more attention than managing fixed assets.  The financial manager cannot simply decide the level of the current assets and stop there.  The level of investment in each of the current assets varies from day to day, and the financial manager must therefore, continuously monitor these assets to ensure that the desired levels are being maintained.  Too large an investment in current assets means tying up funds that can be productively used elsewhere (or it means added interest cost if the firm has borrowed funds to finance the investment in current assets).  Excess investment may also expose the firm to undue risk e.g., in case, the inventory cannot be sold or the receivables cannot be collected.

On the other hand, too little investment also can be expensive.  For example, insufficient inventory may mean that sales are lost as the goods which a customer wants are not available.  The result is that the financial managers spend a large chunk of their time managing the current assets because level of these assets changes quickly and a lack of attention paid to them may result in appreciably lower profits for the firm.  So, in the working capital management, a financial manager is faced with a decision involving some of the considerations as follows:

1.    What should be the total investment in working capital of the firm?
2.    What should be the level of individual current assets?
3.    What should be the relative proportion of different sources to finance the working capital requirements?

Thus, the working capital management may be defined as the management of firm’s sources and uses of working capital in order in maximize the wealth of the shareholders.  The proper working capital management requires both the medium term planning (say up to three years) and also the immediate adaptations to changes arising due to fluctuations in operating level of the firm.

The term working capital may be used in two different ways.

i)    Gross Working Capital (or Total Working Capital):  The gross working capital refers to the firm’s investment in all the current assets taken together.  The total of investments in all the individual current assets is the gross working capital.  For example, if a firm has a cash balance of Rs. 50,000, debtors of Rs. 70,000 and inventory of raw material and finished goods has been assessed at Rs. 1,00,000, then the gross working capital of the firm is Rs. 2,20,000 (i.e. Rs.50,000 + Rs.70,000 + Rs.1,00,000).

ii)    Net Working Capital:  The term net working capital may be defined as the excess of total current assets over total current liabilities.  It may be noted that the current liabilities refer to those liabilities which are payable within a period of 1 year.  The extent, to which the payments to these current liabilities are delayed, the firm gets the availability of funds for that period.  So, a part of the funds required to maintain current assets is provided by the current liabilities and the firm will be required to invest the funds in only those current assets which are not financed by the current liabilities.

The net working capital may either be positive or negative.  If the total current assets are more than total current liabilities, then the difference is known as positive net working capital, otherwise the difference is known as negative net working capital.

The net working capital measures the firm’s liquidity.  The greater the margin (i.e., net working capital) by which the firm’s current assets cover its current liabilities, the better will it be.  Although the firm’s current assets may not be converted into cash precisely when they are needed, still greater net working capital assures that in all likelihood some current assets will be converted into cash to pay the current liabilities.

The distinction between gross working capital and net working capital does not in any way undermine the relevance of the concepts of either gross or net working capital.  A financial manager must consider both of them because they provide different interpretations.  The gross working capital denotes the total working capital or the total investment in current assets.  A firm should maintain an optimum level of gross working capital.  This will help avoiding (i) the unnecessarily stoppage of work or chance of liquidation due to insufficient working capital, and (ii) effect on profitability (because over flowing working capital implies cost).  Therefore, a firm should have just adequate level of total current assets.  The gross working capital also gives an idea of total funds required for maintaining current assets.

On the other hand, net working capital refers to the amount of funds that must be invested by the firm, more or less, regularly in current assets.  The remaining portion of current assets being financed by the current liabilities.  The net working capital also denotes the net liquidity being maintained by the firm.  This also gives an idea of buffer available to the current liabilities.

Thus, both concepts of working capital i.e., the gross working capital and the net working capital have their own relevance and a financial manager should give due attention to both of these.

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